Transfers of Personal Goodwill in the Sale of a Closely Held Business
When it comes time to sell, business owners who have strong relationships with customers can save big on taxes by combining a C Corporation with attribution of personal goodwill to the owner.
by Michael Koppel/The Tax Adviser
The Tax Reform Act of 1986, P.L. 99-514 (TRA ’86), changed the tax landscape in many ways. It created passive activities and at-risk limitations, eliminated many itemized deductions, and changed tax rates. However, from a business acquisition standpoint, the most important change was the repeal of the General Utilities doctrine. Simply stated, the General Utilities doctrine allowed a C corporation to make a tax-free liquidating distribution to its shareholders prior to a sale of the company. This method allowed a C corporation to avoid double taxation on the sale of its assets. The repeal of the General Utilities doctrine was a major reason why so many closely held corporations elected to be S corporations after the enactment of TRA ’86.
While many of the reasons why a family business would consider being a C corporation have been eliminated over the years (the deduction of shareholder health insurance, for example), there are still situations in which the limitations on S corporation ownership are an issue. However, businesses, other than personal service corporations, have another reason to consider C corporation status: In a business in which the owner has a strong relationship with the customers, the C corporation structure combined with attribution of personal goodwill to the owner and not the business can result in substantial tax savings when the business is sold.
Example: ABC, Inc., is an insurance agency. As with most businesses, the owner cannot take all the profits as salary because the business needs equity to fund its growth and other needs. J, ABC’s sole shareholder, is in the 35 percent tax bracket. If he takes $100,000 less in salary, he will pay $35,000 less in federal taxes. In the corporation, the first $100,000 of taxable income would have federal taxes of $22,250 — a tax savings of $12,750. (State and payroll taxes have been ignored; payroll taxes would generate additional tax savings.)
J is now 60 and is considering retiring within five years. He has discussed the sale of his agency, and his accountant tells him that most sales of insurance agencies are sales of assets, not sales of stock. In their discussion about choice of entity, the accountant reminds J that maintaining the C corporation to build equity could result in double taxation. The accountant has a possible solution, which revolves around who owns the goodwill of the agency.
Personal Goodwill vs. Business Goodwill
The concept that personal goodwill can be a separate, salable asset, distinct from the goodwill of the business, is not new. It was defined by the Florida Supreme Court in Thompson v. Thompson, 576 So2d 267 (Fla. 1991), and was clearly documented for tax law purposes in two 1998 Tax Court cases: Martin Ice Cream Co., 110 TC 189 (1998), and Norwalk, TC Memo 1998-270. In all three cases, the question was who controlled the relationships with customers.
There are several factors to consider in determining if the goodwill of a business belongs to the business or to a person. The Thompson case involved a divorce in which the spouse was looking for half the value of a law practice. In that case, the judge distinguished between personal goodwill and professional goodwill. The judge indicated that personal goodwill was the value that resulted from the continued presence of a certain person, and only that person can transfer it.
The Martin case, which involved an ice cream distributor, revolved around the fact that there was no employment agreement between the company and the employee-shareholder. Therefore, the relationships that the employee-shareholder had with customers created personal, not corporate, assets. In the Norwalk case, which involved the liquidation of an accounting firm, the court cited the lack of an effective covenant not to compete in concluding that personal goodwill — the personal ability, personality, and reputation of individual accountants — belonged to the accountants and not to their firm.
The importance of personal goodwill in the sale of assets of a closely held C corporation is significant. If the intangible is owned by the C corporation, its sale will be subject to taxation at both the corporate and the individual level under Secs. 336 and 331. Even if the gain on the sale of the intangible can be offset by compensation, it will likely be taxed at a very high individual tax rate and be subject to payroll taxes. Conversely, if the employee-shareholder controls the goodwill, it will be taxed only at the favorable capital gains rates; because the corporation does not own the goodwill, it will not owe any tax on its sale when the corporation is sold. The buyers will not care whether they purchase the intangible from the corporation or the employee-shareholder; in either case, it will be a Sec. 197 asset amortized over 15 years.
In the example above, J should establish that the goodwill resulting from his relationship with ABC customers is personal and not corporate (and he should avoid having a non-compete agreement). Then, on the eventual sale of ABC, J’s personal goodwill should be transferred directly by J to the purchaser of ABC in a separate asset purchase. J will be subject to tax on the sale at capital gains rates, instead of ordinary income rates, and ABC will not be taxed on the sale of the intangible at all, since it does not own the goodwill.
When closely held businesses consider what type of entity to be taxed as, there is still a place for the C corporation. However, employee-shareholders need to plan their exit strategy carefully.
When properly planned, personal goodwill can result in substantial tax savings.
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Michael D. Koppel, CPA/PFS, Gray, Gray & Gray, LLP, Westwood, MA is a contributing writer for The Tax Adviser. His views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.